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Junk-Bond Bargains Await the Brave

The past few weeks have been scary for almost every type of investment other than Treasury bonds. High-yield bonds, also known as junk bonds, have been hit especially hard: The average high-yield bond fund lost more than 15% during the 30 days through Oct. 9, according to Morningstar.

If you like looking for bargains among downtrodden investments, you might be considering increasing your stake in this high-octane segment of the bond market. Indeed, junk bonds now offer some of the lowest prices and highest yields they ever have, relative to Treasury bonds. Trouble is, junk bonds remain enormously risky.

First, some background. High-yield bonds are issued by companies with relatively weak finances. (Those with credit ratings of BB or lower, as rated by Standard & Poor's.) A shaky balance sheet increases the chances that a company will be unable to meet interest and principal payments on its bonds, and will be forced to default -- hence the securities' trashy nickname. As a result, financially weak borrowers have to offer high interest on their bonds to attract investors.

A small allocation to junk bonds can play a valuable role in a diversified portfolio. The securities' high interest payments can boost the income your portfolio throws off. What's more, high-yield bonds have the potential for strong returns: The average high-yield bond fund gained more than 24% in 2003, according to Morningstar.

But junk bonds carry risks that are commensurate with their potential rewards. Economic downturns increase the odds that weak companies will default on their debts, typically causing investors to sell off high-yield bonds rapidly, as they have in the past month. Selling pushes the bonds' prices down and drives their yields up.
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